The Oil Rout’s Surprise Victims

The epic collapse in the price of oil, from more than $100 per barrel less than two years ago to below $30 earlier this past week, has crushed investors in the futures market, energy partnerships, high-yield corporate bonds and the shares of oil and gas companies.

But it is also wreaking havoc on investors in short-term bonds issued by leading banks.

In 2015, units of Bank of America Corp., Citigroup, Credit Suisse Group AG, Goldman Sachs Group, J.P. Morgan Chase & Co., Morgan Stanley, UBS Group AG and other top financial firms issued at least 300 “structured notes,” or short-term borrowings, whose returns are linked to the price of oil or other energy-related assets. These securities total at least $1.3 billion.

The buyers include wealthy families, individual investors, and brokers and financial advisers who want to limit the risk or amplify the return of more-conventional investments.

Typically maturing in two years or less, these notes pay commissions of about 2% to the brokerages that sell them. They use intricate combinations of options contracts to skew the payoffs from changes in energy prices: You can make a lot of money if oil goes up a little, and you can lose much or all of your money if it goes down a lot.

And oil has gone down a lot.

“The vast majority of them are underwater,” says Joseph Halpern, chief executive of Exceed Investments, a New York-based firm specializing in these types of investments. “And a lot are materially underwater. On many of them, you’d need a 50% to 100% jump in the price of oil from today’s levels to get back to break-even.”

Consider $6.9 million in one such security, issued by HSBC USA last May and distributed by Morgan Stanley Wealth Management. Linked to the share price of the Energy Select Sector SPDR, an exchange-traded fund of about 40 leading oil and gas stocks, the notes mature in September 2016 and promise to triple any gain in the share price of the fund — but only up to a point.

When the note came out, the ETF was priced at $78.37, down from more than $100 in the summer of 2014. If it rises to $82.54, or a mere 5.33%, by the end of August, then the note will triple that — paying out a 16% capital gain upon maturity.

However, investors can’t earn more than 16%, no matter how much higher the ETF goes.

And if the fund goes down instead of up, investors in the note will lose money — dollar for dollar, without limit.

Mind you, most of these securities don’t start maturing until late 2016, and the prices of oil and related assets could well recover by then — in which case the interim losses would disappear or turn into gains.

“But this is not really an investment strategy so much as a wager on which way oil prices are going,” says Craig McCann, principal at Securities Litigation and Consulting Group, a research firm in Fairfax, Va. “And some of the risks and costs of that wager are masked by the complexity of it.”

Furthermore, there isn’t any secondary trading in most of these securities, meaning that the issuing bank may often be the only buyer. The HSBC-Morgan Stanley note, at an original principal amount of $10, had a projected value at maturity of about $7.23 and would attract a bid of $7.02 as of this past Thursday, says HSBC spokesman Rob Sherman.

He says the firm works with brokers and advisers to provide investments that “address a wide variety of their customers’ needs and market views” and that its offerings include “robust disclosures on investment risk.” The prospectus for the notes warns that “investors may lose up to 100%.”

“We believe that we do extensive disclosure of the risks of these issues,” said James Wiggins, spokesman for Morgan Stanley Wealth Management, “and they are designed as hold-to-maturity investments.”

Even so, such notes — unlike regular bonds — offer little or no assurance of returning your money at maturity. In this case, you will recover all your initial investment only if oil-company shares rise by at least 38% between now and the end of August.

Many people who thought they were buying black gold on the cheap appear to own a black hole instead, with limited means of escape.

If, for some reason, you think you know when and how far the price of oil will recover, you can always buy an ETF specializing in energy stocks. Your bond portfolio is the last place you should be rolling the dice.